Thursday, August 14, 2008

It has been noted here on many occasions previously that future historians will have a field day when assessing economic activity during the last few decades. Nowhere will the puzzlement be more profound than when they turn to the measure of home ownership costs in the government's inflation statistics - owners' equivalent rent.As shown above, there is nothing "equivalent" about the price of housing and how home ownership costs are represented in the consumer price index.

For those not familiar with the history, it can be summarized as follows:

In 1983, after an era of soaring inflation and the biggest housing boom and bust since World War II, estimated rental costs were substituted for such sensible measures like mortgage payments, taxes, and insurance in the "official" government measure of inflation.

Since then, the rising cost of home ownership has been barely noticeable in the cost of living (at least the way the government measures it), much to the benefit of the pencil pushers in Washington who are rewarded with lower cost increases for payments indexed to consumer prices - little things like social security.

None of this mattered much until after the internet bubble went bust and the Greenspan Fed started looking for a new bubble to inflate. Fast forward to today and it's clear to see how distorted the reporting of consumer prices became in the new decade.

Substituting the Case-Shiller Home Price Index for owners' equivalent rent shows the following divergent measures of inflation, where the "pedal to the metal" one or two percent short-term rates from 2002 to early-2005 look, ahem, "inappropriate" at best.Even more surprising, when factoring in today's plunging home prices, the annual rate of inflation, reported at a 17-year high of 5.7 percent earlier today, recently dipped into negative territory and currently stands at less than one percent.

But it gets even better...

Since much of headline inflation comes from food and energy, stripping those out of the most recent inflation data and substituting the Case-Shiller Home Price Index for owners' equivalent rent shows core inflation, economists' favored measure of inflation, now at about minus 4 percent.Since OER accounts for almost one-third of core inflation, it has a much bigger impact than for overall inflation as shown clearly above - both at the height of the housing bubble in 2004-2005 and now as the housing bubble has gone bust in 2007-2008.

When including soaring home prices instead of the tumbling cost of rent in 2003 (back when anyone and everyone was buying houses with no money down, bidding home prices skyward while pulling the rug out from under the rental market), core inflation would have measured more than four percent, not the one percent reading that is now characterized as the "2003 deflation scare" among dismal scientists.

The historians will not be kind when they pass judgment on current day economists.

Notes:1. The charts above use a simple substitution of the Case-Shiller Home Price Index for owners' equivalent rent and are not intended to duplicate the pre-1983 measure of home ownership costs calculated by the Bureau of Labor Statistics.2. The first chart above was featured in Kevin Phillips' recent book Bad Money (highly recommended reading) as discussed here previously.

5
comments:

Anonymous
said...

it served the purpose of not making thr banks and fed pay out fair interest to savers by not counting house price inflation as inflaion, by using this bogus calculations thus savers will need 20 years of 20 percent interest rates and no housing price inflation just to break even on the purchace power of their "saved" dollars....

Tim, your graph is something I make frequent use of (for eample, here), because I think it captures something unique and important; namely, the respective strengths of the opposing forces of (import) inflation and domestic asset deflation. No other chart or graph by any blogger or agency does so nearly as well.

If China is not decoupling from the world economy (and I don't think it is), then when it slows, the forces of deflation will probably overwhelm the forces of inflation, and your graph will be the first to show it.

While I generally think CPI understates inflation and don't like manipulations, the fact is that using changes in housing prices to measure CPI would be akin to measuring changes in the stock market to measure inflation - misleading. Only a small percentage of people buy a home any given year and there are the only people affected - the great vast majority have their mortgage costs "locked in", whether or not the mortgage is paid off, and the inflation is exactly 0% for them.

Another factor which would misstate housing price changes is interest rate changes. Even if a house price remains unchanged, if interest rates change, payments would go up - so should that be measured in inflation, or not (i.e., do you measure housing values, or monthly payments).

One approach you might take is to measure the delta in the arithmetic mean of the prices paid for all houses owned (whether or not purchased that year), if you could get that data.

But using rental rates is not a bad approach either. This is because the CPI should measure the cost of living and with respect to asset classes which are historically cyclical (such as stocks and homes), and particularly with assets that are only purchased by a very small percentage of the economy in any given year (yet produces a huge component of living costs), using asset prices would be even more misleading.

Please see note 1 - this is not intended to duplicate pre-1983 calculations. Also, people buy homes more frequently than they buy many durable goods such as refrigerators - despite what some people have come to believe, a house is more of a durable good than an investment.